AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final regulations.

SUMMARY:

This document contains final regulations under section 704(c)
of the Internal Revenue Code (Code) providing that the section 704(c)
anti-abuse rule takes into account the tax liabilities of both the
partners in a partnership and certain direct and indirect owners of
such partners. These final regulations further provide that a section
704(c) allocation method cannot be used to achieve tax results inconsistent
with the intent of subchapter K of the Code. The final regulations
affect partnerships and their partners.

DATES:

Effective Date: These final regulations
are effective June 9, 2010.

Applicability Date: These final regulations
are applicable for taxable years beginning after June 9, 2010.

FOR FURTHER INFORMATION CONTACT:

Bryan A. Rimmke at (202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to 26 CFR part 1 under section
704 of the Internal Revenue Code (Code). On May 19, 2008, a notice
of proposed rulemaking (REG-100798-06, 2008-1 C.B. 1135) was published
in the Federal Register (73 FR 28765)
in response to the Joint Committee on Taxation’s recommendation
that the partnership rules be strengthened to ensure that the allocation
rules in the regulations under section 704(c) are not used to generate
unwarranted benefits. See The Report of Investigation of
Enron Corporation and Related Entities Regarding Federal Tax and Compensation
Issues, and Policy Recommendations, (JCS-3-03) February
2003 at pg. 220. Because no requests to speak were submitted by August
18, 2008, no public hearing was held. Written comments, however,
were received in response to the notice of proposed rulemaking. After
consideration of these comments, the proposed regulations are adopted
without change by this Treasury decision.

Summary of Comments and Explanation of
Provisions

The comments on the proposed regulations requested that examples
be given to specifically describe the types of transactions to which
these regulations apply. Additionally, the comments requested examples
to describe the types of transactions which would not be abusive under
this regulation but would be abusive under the general subchapter
K anti-abuse rule found in §1.701-2. In light of the fact that
these regulations are anti-abuse provisions and the factually intensive
analysis needed to determine whether this regulation is applicable,
the Treasury Department and the IRS decline to adopt these comments.

Additional comments requested that the Treasury Department and
the IRS consider both a de minimis partner rule
for direct partners similar to §1.704-1(b)(2)(iii) and a rule
for indirect partners where the owners would need to be related to
the look-through entity within the meaning of sections 267 or 707
in order to be considered indirect partners for the purposes of the
regulation. For purposes of §1.704-1(b)(2)(iii), a de minimis partner is any partner, including a look-through
entity, that owns less than 10 percent of the capital and profits
of a partnership, and who is allocated less than 10 percent of each
partnership item. The Treasury Department and the IRS have determined
that neither a de minimis partner provision nor
a related partner provision for indirect partners would conform to
the intent of this anti-abuse provision and therefore decline to adopt
such rules.

This Treasury decision adopts the proposed regulations without
substantive change. Accordingly, the regulations amend §1.704-3(a)(10)
to provide that, for purposes of applying the anti-abuse rule, both
direct and indirect partners are considered. The final regulations
provide that an indirect partner is any direct or indirect owner of
a partnership, S corporation, or controlled foreign corporation (as
defined in section 957(a) or 953(c)), or direct or indirect beneficiary
of a trust or estate, that is a partner in the partnership, and any
consolidated group of which the partner in the partnership is a member
(within the meaning of §1.1502-1(h)). However, an owner of a
controlled foreign corporation is treated as an indirect partner only
with respect to the allocation of items that enter into the computation
of a United States shareholder’s inclusion under section 951(a)
with respect to the controlled foreign corporation, enter into any
person’s income attributable to a United States shareholder’s
inclusion under section 951(a) with respect to the controlled foreign
corporation, or would enter into the computations described in this
paragraph if such items were allocated to the controlled foreign corporation.

These final regulations further provide that the principles
of section 704(c), together with the allocation methods described
in §1.704-3, paragraphs (b), (c) and (d), apply only with respect
to the contributions of property to the partnership. In that regard,
the anti-abuse rule of §1.701-2(b) provides that, if a partnership
is formed or availed of in connection with a transaction a principal
purpose of which is to reduce substantially the present value of the
partners’ Federal tax liability in a manner inconsistent with
the intent of subchapter K, the IRS may recast the transaction for
Federal tax purposes as appropriate to achieve tax results that are
consistent with the intent of subchapter K. Thus, even though a transaction
may satisfy the literal words of the statute or regulations, the IRS
may recast a transaction as appropriate to avoid tax results that
are inconsistent with the intent of subchapter K, including but not
limited to: (i) disregarding purported partnerships, in whole or part,
so that partnership assets are treated as owned by the partner; (ii)
disregarding one or more contributions or (iii) disregarding one or
more purported partners. The final regulations also provide that,
in determining if a purported contribution of property to a partnership
should be recast to avoid results that are inconsistent with subchapter
K, one factor that may be relevant is the use of the remedial method
in which allocations of remedial items of income, gain, loss or deduction
are made to one partner and allocations of offsetting remedial items
are made to a related partner.

Effective/Applicability Date

These regulations apply to taxable years beginning after June
9, 2010. No inference should be drawn from this effective date with
respect to prior law.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also
been determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply to these regulations, and
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Code, the notice
of proposed rulemaking was submitted to the Chief Counsel for Advocacy
of the Small Business Administration for comment on its impact on
small business.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to
read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.704-3 is amended by:

1. Adding four sentences to paragraph (a)(1) at the end of
the last sentence and revising paragraph (a)(10).

2. Revising the first sentence of paragraph (f) and adding
one sentence to the end of the paragraph.

The revisions and additions read as follows:

§1.704-3 Contributed property.

(a) * * * (1) * * * The principles of this paragraph (a)(1),
together with the methods described in paragraphs (b), (c) and (d)
of this section, apply only to contributions of property that are
otherwise respected. See for example §1.701-2. Accordingly,
even though a partnership’s allocation method may be described
in the literal language of paragraphs (b), (c) or (d) of this section,
based on the particular facts and circumstances, the Commissioner
can recast the contribution as appropriate to avoid tax results inconsistent
with the intent of subchapter K. One factor that may be considered
by the Commissioner is the use of the remedial allocation method by
related partners in which allocations of remedial items of income,
gain, loss or deduction are made to one partner and the allocations
of offsetting remedial items are made to a related partner.

* * * * *

(10) Anti-abuse rule—(i) In general. An allocation method (or combination of methods)
is not reasonable if the contribution of property (or event that results
in reverse section 704(c) allocations) and the corresponding allocation
of tax items with respect to the property are made with a view to
shifting the tax consequences of built-in gain or loss among the partners
in a manner that substantially reduces the present value of the partners’
aggregate tax liability. For purposes of this paragraph (a)(10),
all references to the partners shall include both direct and indirect
partners.

(ii) Definition of indirect partner. An indirect partner is any direct or indirect owner of a
partnership, S corporation, or controlled foreign corporation (as
defined in section 957(a) or 953(c)), or direct or indirect beneficiary
of a trust or estate, that is a partner in the partnership, and any
consolidated group of which the partner in the partnership is a member
(within the meaning of §1.1502-1(h)). An owner (whether directly
or through tiers of entities) of a controlled foreign corporation
is treated as an indirect partner only with respect to allocations
of items of income, gain, loss, or deduction that enter into the computation
of a United States shareholder’s inclusion under section 951(a)
with respect to the controlled foreign corporation, enter into any
person’s income attributable to a United States shareholder’s
inclusion under section 951(a) with respect to the controlled foreign
corporation, or would enter into the computations described in this
sentence if such items were allocated to the controlled foreign corporation.

* * * * *

(f) Effective/Applicability Dates. With
the exception of paragraphs (a)(1), (a)(8)(ii), (a)(8)(iii), (a)(10),
and (a)(11) of this section, this section applies to properties contributed
to a partnership and to restatements pursuant to §1.704-1(b)(2)(iv)(f)
on or after December 21, 1993. * * * Paragraphs (a)(1) and (a)(10)
of this section are applicable for taxable years beginning after June
9, 2010.

Linda E. Stiff, Deputy Commissioner for Services and Enforcement.

Approved May 28, 2010.

Michael Mundaca, Assistant Secretary of
the Treasury (Tax Policy).

Note

(Filed by the Office of the Federal Register on June 8, 2010,
8:45 a.m., and published in the issue of the Federal Register for
June 9, 2010, 75 F.R. 32659)

Drafting Information

The principal author of these final regulations is Bryan A.
Rimmke, Office of the Associate Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury
Department participated in their development.